State-owned conglomerate Dubai World’s decision to ask creditors to freeze debt payments has prompted worldwide worries. But it could also bring a nasty religious element into the financial markets, as the first bond repayments due are $3.52bn of Islamic bonds, or sukuks, due next month from property arm Nakheel.
My colleague Willem Buiter on his Maverecon blog warns that treating local investors or Islamic creditors differently to western creditors could increase the damage to Dubai’s reputation:
If Islamic debt were to be interpreted by the Dubai authorities as debt instruments that give preferential treatment – non-contractual seniority – to Islamic creditors, Dubai’s reputation would be damaged severely.
But the structure of Islamic debt might make this happen anyway. Due to a ban on usury, or paying interest – only fully abandoned in the 17th century by the Catholic church – Islamic bonds are set up so investors share risk with the borrowing company. In effect, Nakheel’s bond issue is a sale and leaseback deal. In theory, this should mean the bondholders not only can seize the assets on which the bond is secured: they actually own them. In practice, legal arguments are under way to see whether Islamic bondholders take precedence over ordinary bondholders in defaults such as those of Kuwait’s Investment Dar and Saudi Arabia’s Saad Group, and it remains unclear whether it will turn out this way.
Given the sukuks are designed to conform to Islamic law by ensuring the bondholders share risk with the company, it would be ironic indeed if they end up being given priority in repayment. It is unlikely western holders of ordinary Dubai World bonds would be happy with such an outcome, even if it is simply a consequence of the small print.
But if the emerging law ends up giving priority to sukuk investors in a default, and Dubai World defaults on all its debt, Dubai will be stuck in a nasty position.
Following the law and giving priority to Islamic investors would be taken by many as a case of Dubai helping those who follow the national religion – something financial markets would be unlikely to forgive, and which could drive a stake through the heart of the already struggling efforts to turn Dubai into a global financial centre. But not following the law would overturn the myth that an absolute monarchy can have a full rule of law in the first place, something which would also scare off potential international investors.